Questioning Jim Cramer On The Merits Of ETFs

Chris Holt sent me an article from TheStreet.com summarizing a video interview with Jim Cramer on his opinions of ETFs.

The article’s a bit vague on details, but the video is quite clear. I’d say that Cramer goes to great lengths to bash the industry as one that does not really care about the needs of the client/investor. He starts out by characterizing the industry as one involved in a “corrupt process”. Just like any merchandiser, he says they’re "pushing products". I can’t really argue with that. In an industry revolving around money, there will always be conflicts and biases, some more visible than others due to one’s position or background within the industry.

Whether the comments made on the industry are especially relevant to ETF providers, I’m not so sure. Like mutual funds, it’s all about building the assets under management. Newer products with better sizzle are what sell. For better or for worse, ETFs seem to be what’s hot right now. Could it simply be that ETFs are gaining market share from traditional mutual funds? (More on that later when I bring up some recent stats from AMG Data.)

There are many points in the video that are obviously one sided. Commissions driving the ETF push? What about I-banks pushing stocks with buy recommendations left, right and center even after all the regulatory brouhaha after the market collapse of 2000-2002? What about prime brokerages doing whatever they can to fight for hedge fund business that pays top dollar for various services and with the desk making great margins on the related trading activity? I don’t see the ETF push being that significant in the realm of commissions versus other entries in the income statement for the I-banks.

With regard to the idea of “anti-diversification”, Cramer’s talking about the new wave of ETFs that are highly focused in a sector like nanotechnology or a certain area of healthcare (cancer drugs for example). No doubt he’s got a point there. But, his example of 5 stocks (Microsoft, Marvell, HP, CA, Merck) versus an ETF is unclear. I suppose what Cramer is saying is that whether you choose a few tech stocks or one of the newer, highly niche sector ETFs, in both cases you’re not getting diversification. That’s true and I’m betting that anyone who implements in any of these two ways is consciously and purposely making a bet in that sector. The question is if you want to make a bet in a specific sector, do you go with some direct stock picks or a sector fund/ETF? To each his own, but not everyone is a pro with the resources (especially time) to make a precise decision. This is just one of the many reasons for the ETF.

The issue I have with the above is highlighted when Cramer says “… I want to be in a sector fund which is an ETF” at about the 1:50 mark of the video. The context of this quote is not that Cramer wants to be in a sector fund/ETF, but that he equates sector funds to ETFs. So you can see he is focusing on the new niche sector ETFs. Like I said earlier, his is a worthy comment if the point is that there are too many products being pushed into the market, each covering a very specific area. But like I’ve also said many times before, if the market is allowed to take its course, unwanted funds will disappear. Maybe there’s a flaw there, but the Pontiac Fiero and Aztec are other examples where the market decided and the product was pulled earlier than likely expected by the manufacturer.

Simply put, equating sector funds with ETFs is wrong. Cramer knows that ETFs are more than simply a means for a sector play. You can get broad global exposures, regional exposures, country specific exposures as well as style based, cap based and sector based exposures. We’re also getting into alternative investment territory. ETFs are like tools in your toolbox, animals in a biosphere and hedge funds. There are many types, all with varied purposes some more useful than other depending on your point of view.

Near the end of the video clip, Cramer says ETFs should be avoided and that a portfolio of ETFs is just a mutual fund. That is somewhat true if you are overdiversified, long only and are in a generally static state. What’s hilarious is the fact that that he thinks it’s preposterous to try to be anything like an index fund because of the "… empirical nature of the returns I’ve been generating on my show."

There you go. Some may perceive ETFs as a threat to their OM. As more investors use ETFs, they have less use for shows like Cramer’s and specific stock calls.

But let’s be honest… they’re no threat to Cramer or anyone else. Indexing, ETFs and related methods will never be a threat to the active investor, Jim Cramer or his media efforts. We live in a world where everyone (or at least nearly everyone in the investment industry) thinks they’re better than the rest. It’s part of the modern capitalistic world and it’s what allows for progress and innovation… and that’s good. Greater effort leading to greater achievement should be rewarded. Our industry is one where most have been leaders and overachievers since the sandbox. Thus, based on this, how can we then possibly settle for “average”? Many investors can’t. The investment industry won’t. So, indexing as a means of investing will never take over the world… and rightly so.

Aside: The evidence from Standard and Poor’s and their SPIVA scorecards seem to show that index returns are anything but average. The index return may not always be top quartile, but long-only managers seem to be having a hard time keeping up with the “average” in the longer term.

What I believe is that, in the search for alpha, ETFs are just another trading instrument like derivatives, closed end funds, or specific stocks or bonds. For some investors, having a portfolio of 5 ETFs held for the long term is what’s appropriate. For some, it’s trading a portfolio of 50 to 100 stocks with roughly 200% annual turnover. To each his own. ETFs can be played in so many ways just as derivatives or even a small basket of actively managed stocks.

Think of these as ingredients. I can give ten ingredients to ten chefs and you’d get ten menus of varied offerings (ever watch the Iron Chef?!).

The market would seem to agree. This is from Friday morning’s “Early Look at the Market” email from Bear Stearns:

Including ETF activity, Equity funds report net cash inflows totaling $10.756 billion in the week ended 2/7/07 with Domestic funds reporting net inflows of $8.486 billion and Non-domestic funds reporting net inflows of $2.270 billion;

Excluding ETF activity, Equity funds report net cash inflows totaling $2.571 billion with domestic funds reporting net inflows of $1.210 billion and Non-domestic funds reporting net inflows totaling $1.361 billion. – AMG Data

Equity inflow statistics show that it’s the ETF activity that is significant. Thus, it’s not surprising that nearly every business media outlet has some sort of coverage in the ETF space. This even includes TheStreet.com. From this recent article you get an update on TheStreet.com Ratings' model ETF portfolio which is a “theoretical portfolio of 10 ETFs that we use to track market trends”. Furthermore, the article states that “TheStreet.com's Ratings coverage universe now consists of 216 of the 362 actively monitored U.S.-traded ETFs.”

So, first, TheStreet.com seems to have enough coverage of ETFs to even warrant the construction of a sample portfolio consisting only of them. Second, although I won’t comment on the merits of this portfolio specifically, it does look nicely diversified to me.

In isolation, a niche sector fund may be anything but diversified and I think investors realize this. Using ETFs, whether exclusively or not, within a broader portfolio is an excellent way to establish the required diversification for any type of investor. Not everyone will buy in to them but many will for many, many different reasons. ETFs allow for more choice. If Cramer really cared about the investor… no reason to think he doesn’t… he’d realize that that means something.

Comments

[Paul Meisel:]

His comments, and this article, intrigued me enough to listen to the video two or three more times, plus to check his blog and look at some of his other articles to try to fit the comments into context.

I think the key to his comments is that he is a stock picker by nature. In another interview he said he never wanted to be in a fund or ETF -- because he would own the bad stocks in the group as well as the good ones.

The basic idea behind the beginning of index investing was that, due to efficient markets, investors cannot pick winning companies, or sectors, or good times to get in or out of the market -- so get into everything, and ride the growth of the economy over the long haul at low rates.

The variety of ETFs and their use seems to indicate that many ETF purchasers believe that they can pick or time sectors to some degree, and possibly the market as a whole, but they prefer to avoid individual company risk. And one strategy that I have read about indicates that ETFs are used as part of an individual company play (buy the best company and short the ETF, or buy the ETF and short the worst company).

My work experience as a corporate financial manager puts me more in Cramer's camp -- I would rather take some individual company risk based on my ability to evaluate the business. This is a Buffett idea as well. But in many conversations with my financial-planner sister, I have come to realize that there are many investors with limited financial analysis skills, for whom the index investing concept is preferable. And some of them have strong business and financial skills in certain sectors, with very limited knowledge in others -- so for them, a mixed strategy may be appropriate, owning some individual stocks mixed with some ETFs.

The proliferation of product is not necessarily bad, it just is what it is -- a product offering by an entrepreneur hoping to make a profit. As long as we don't confuse it with charity and shop wisely, we should be OK. But if I was counseling a young person (and I often do) I would tell them to learn to analyze financials and businesses and become a company and stock picker. I personally believe ETFs are best for those who use them to overcome their personal uncertainty or lack of knowledge/research/tim...

2007 Feb 13 04:30 PM

[Richard Kang1:]

Makes a lot of sense. The only thing I wonder is when you say "... there are many investors with limited financial analysis skills", I don't think we're talking about people with an accounting degree or a CFA - that would be overkill. However, I'm guessing that the vast majority of investors have next to no financial analysis skills. If many people can't keep proper track of their own budget and banking, it's no surprise that they don't do break open the annual reports for company stocks that they hold, never mind calculating some basic ratios from the financial statements. Luckily, we're at a time when the internet allows for free and easy access to information (too much, really) so that keen investors can make decisions in ways you've suggested, PM. But despite this, I'm thinking that there may be a growing trend where investors choose to implement their decisoins with ETFs where possible and use direct stock picks as the next best alternative. I'm sure there are vastly more who look at things the other way around but it's the trend that I may (or may not) be right on.

2007 Feb 13 05:37 PM

[Paul Meisel:]

I agree that overall, there are a lot more people that should be mostly in ETFs and funds, than mostly in individual stocks. That may change with a generally more sophisticated investor population, but I think that the simplified approach will be preferred for a majority for a long time to come.

2007 Feb 13 08:12 PM

[ray b:]

It seems to be a valid techniques these days to say that every other method is corrupt but the one being touted.

2008 Dec 12 09:36 PM

[King T:]

Mr. Kang is too apologetic in this article. Cramer is an overrated, over-emotional trader that is a perma-bull. He spent his entire career obtaining insider trading tips to make his customers money. It is extremely easy to pick stocks in a bull market, but his performance speaks for itself during this downturn. Calling for investors to jump in heavy when the Dow was 14000 and calling a bottom on multiple occasions on the way down show his lack of technical and fundamental trading knowledge. Now he is reverting to the blame game on his show instead of performing the due diligence in order to help his investors. The truth is we will see S&P earnings near $60-$65. Markets bottom at roughly 10x PE. That places us at roughly 600-650 on the S&P 500. So it would be pretty safe to say that we will retest the bottom...so why bottom fish now?

Remember when this crook was touting Crystallex and Sirius Radio? He never gave up and never told investors to use their stop losses. Good thing us true traders know how to short the market!

ETFs are here to stay because they offer broad diversification. Double and triple levered ETFs are also positives for investors because it allows for leverage without having to play options. The most beautiful thing about them is they offer long and short positions while reducing the hypocracy of mutual fund managers. Next time you see your invoice, call your mutual fund manager and ask him for a breakout of the fees charged within the year. Hope you enjoy...

Jan 09 03:37 PM